The Art of Trade War
"Commerce with all nations, Alliance with none, should be our motto"
-Thomas Jefferson
I made my buys for the year on December 28, 2017, see the new portfolio here (Click Here).
I've been asked repeatedly to say something about the Trade War of 2018. I've resisted, mainly because I didn't think it matters much to the Mother's Little Helper portfolio. I've also resisted because, frankly, there's no upside for me in this. No matter what my position is I'll get a few hundred flame mails from one faction or another.
I'm giving in to my readers request that I comment, this is a really long comment and one that must be understood from the way I look at the markets and politics. To understand this post requires an understanding of me. For this I provide some background below.
Thesis
Balanced fair trade is not the goal, it’s the deception
The trade war will be short lived, but longer than anyone really wants
At stake is global economic power for the next century
Background
This article is going to move around a lot. Think of it like a Bond movie where Bond, James...Bond, chases the villain across several countries before pinning him down and forcing the truth out. Grab some popcorn and a soda and enjoy the ride. Like a Bond movie you may need to suspend your disbelief at times, step out of your own politics, religion and ideology to allow events and the data to tell a story. I don’t have a Q to give me cool gadgets but my willingness to step away from my own emotions is what I feel provides me with my cool gadget edge over my nemesis; namely the global markets. I tend to be a contrarian investor, which simply means I like to invest in areas that the rest of the market hates; read as, my views may not align with yours and that doesn’t make either of us wrong.
A substantial number of new readers have joined this blog and so for the benefit of those that haven’t read any of my posts I’ll simply restate a few things about myself that may be helpful. I don’t belong to a political party or support any specific politicians; not even a yard sign, I still believe that my vote is private. I haven’t support Clinton or Trump, but I do support the idea of a non-partisan debate platform that brings in a third party or two. I don’t belong to a church or espouse any particular religious beliefs, but I do believe in the Law of Attraction. I read about 25 blogs with significantly different points of view. I listen to CNBC (US, China, Australia and European reports), MSNBC, CNN, Bloomberg, Fox and NPR news, The Good News Network, Twitter and Facebook, the Wall Street Journal, and most articles on CNBC and AP news. I also read a lot of books, typically on subjects I don’t know much about and historical figures. Being a news and book junkie forces me to dig deeper on esoteric issues like, what’s the International Maritime Organization up to? What are the latest developments in Immunotherapy and human implanted micro-chips? My news consumption takes up about 4-5 hours of the day; it’s like a second job while I’m doing my job but I’ve found that the more I consume, the less stressed I am about world events. The science behind that personal discovery was revealed to me in the book The Elements of Journalism 3rd edition, I highly recommend the book. I don’t claim to be without bias, but I’m comfortable that I’m not freaked out by any particular event. It’s never my intention to convert, offend or provoke anyone, I’m far more interested in the exchange of ideas.
We can howl at the moon on Twitter and Facebook,
Or we can use our talents to make a small dent in the Universe.
Honor your talents, make that difference.
-Clay Baker
Myths
I can’t objectively look at trade wars if I accept as fact all the sound bites that fill the news about trade wars. Besides, in contrarian investing you go to where the crowd isn’t. My own experience has been that when everyone is shouting the same message, more often than not, they’re wrong.
The trade wars we’re having today have a lot of moving parts, but I think the objective lies out in the fog, we don’t see it yet because we’re not conditioned to think long term. Why do we call someone a ‘Visionary’ who looks out 10-20 years, I would say that’s simply being thoughtful and pragmatic.
The headlines around trade wars sound like this; “no one wins”, “trade wars are easy to win”, “look at what happened with the Smoot-Hawley Act, it caused the Great Depression”. I have to squash that one right now. Even free trade economist Milton Friedman thought Smoot-Hawley had little to do with the Great Depression. The Great Depression started on October 29, 1929 when the stock market crashed. Smoot-Hawley didn’t get passed until June 1930 and was being debated long before. To compare today’s trade wars to the Smoot-Hawley Tariff Act of 1930 is to completely misunderstand the events of today and yesterday. Trade in 1930 was only 9% of U.S. GDP, so how Smoot-Hawley could have caused the Great Depression is hard to support. Furthermore, the data simply doesn’t show that Smoot-Hawley extended or exacerbated the Great Depression either. Total imports at that time were on a long term decline; even after the 1934 Tariff Act that ended Smoot-Hawley, total imports continued to decline. Maybe protectionism was a result of the Great Depression, not the cause.
The great myth is that we know all about trade wars and how they will ultimately work out because our experience with tariffs and trade wars in the past was negative or felt negative. I suspect that Og, the first human who tried to harness fire burned his fingers. What if Og had said to his wife Ug, “I burned my fingers, if you touch that you’ll burn your fingers too, stay away, stay very far away, fire is dangerous and can never be good.” There are many dangerous things that when used properly can had positive results, but when used improperly can have disastrous results. I’m pretty confident that what really happened is Og burned down the cave and Ug his devoted wife cleaned up the mess, found a useful purpose for fire and sent him off to a safe place to do no harm; his ‘Man Cave’.
Another myth is ‘All trade is good’. This one needs a disclaimer every time it gets repeated. In the early 1990’s flat panel displays, a U.S invention, were dumped at below cost prices on the U.S market. Even with high tariffs, flat panel displays are predominantly made in Taiwan. Consumers got lower prices, but at what cost. There are many examples of trade that’s not good, so while I believe in free and open markets, let’s recognize when trade is being used to intentionally destroy competition in order to monopolize an industry.
Global Synchronized Growth
In the 4th quarter of 2017 most economist agreed that Global Synchronized Growth was in fact underway. This may be the first time many investors have ever experienced Global Synchronized Growth, a term first identified in the early 1970’s just before the OPEC oil embargo and last heard just prior to The Great Recession in 2008. Around the world in 2017, revenue and earnings had grown year-over-year and analysts were projecting that the future was even more optimistic. Worldwide manufacturing was up, U.S. exports were up, bolstered by a weaker dollar, optimism from corporate CEO’s was up and small business optimism was at its highest levels since 2014. In late 2017 Deutsche Bank’s chief international economist commented that “global economic health had never been more robust....We have never seen a smaller number of countries in recession.” Data supporting the global synchronized growth story flowed from all directions and not a single developed nation was in contraction. The world economy looked so good that headlines about “Is This a Bubble” began to dominate the news. In fact 2017 was one of the easiest years on record to make a profit in the stock market.
When 2017 third quarter earnings reports came in, 75% of U.S. S&P 500 companies reporting had delivered earnings per share in excess of their 5 year averages. Looking at Europe, 65% of MSCI Index companies had beaten their third quarter expectations. This was real, growth was being driven from all sectors by revenues and real earnings. The conviction test, the DOW Jones transportation index showed that the transports were up; bull markets don’t last without the transports. The tax cuts were still in the Senate and hadn’t entered into the U.S. economic picture yet, but investors were clearly hopeful the tax cuts would pass as indicated by the share volumes trading around any news on the cuts. The stories of the day were focusing on who the big winners would be based on effective tax rates and overseas cash hoards. My own analysis found that Cigna Insurance would see over a 50% drop in their effective tax rate if corporate rates dropped to 21%. Cigna stock climbed to $226 a share by January 2018 in anticipation. Today Cigna trades at only $177 because that 50% reduction in taxes hasn’t been priced into the stock; expect about a 20-25% increase in share price when this occurs. Apple would be able to bring home $250 Billion dollars in cash at a greatly reduced rate due to the repatriation clause of the tax cuts. Every publicly traded company will have to be repriced to account for the compression of price/earnings ratios as a result of tax cuts and newly available investable cash. As I write this on July 19, 2018, those tax cuts, repatriation and the impacts of lower taxes are not fully realized in stock prices. My guess is we are still 1-2 years away from seeing all the impacts of the tax cuts and repatriation of cash as it will take that long for corporations to figure out how to implement the new tax code in their business and how they want to use the cash they bring home.
In a nut shell, the U.S. economy is strong and doing well. When the tax cuts and repatriation of overseas cash kicks in we’ll be doing even better. In fact, I anticipate that the job market will become so tight that immigration reform will become the single most important factor that enables the U.S. economy to continue growing.
Understanding the Trade War
The fervor over tariff’s, trade wars and the many potential impacts on our economy are fascinating to me. The surface of these issues is revealed in headlines and if all you do is look at the surface what you see is pretty scary. I don’t discount that all this makes for great TV and Radio, however our focus should be on how any of this will impact our businesses, income, savings and investments. If your own interest in the trade wars is connected to a social or political agenda I would stop reading right here; I don’t have one to share or promote, I simply want to understand how these events will impact the economy and investing for our future.
First, we can’t discuss tariffs and trade wars without discussing President Trump, President Xi Jingping, Vladimir Putin, Angela Merkel and possibly the rest of the global leaders that are in Trump’s cross-hairs. One way to understand people you don’t know is to look at what they read and which books they recommend to others. Since I can’t stroll into Mara Lago or The White House to see what the President is reading I had to put together a list from reliable sources. One book stands out because we can see evidence of it in many events, The Art of War by Sun Tzu, a 2000 year old Chinese text on military strategy. Angela Merkel’s book list can be compressed down to one text Transformation of the World by historian Jurgen Osterhammel. I’ll save you the 1,500 page read by saying, we can detect his influence in Merkel’s worldview, particularly where he covers globalization, migration and technology. Xi Jingping’s book list is as extensive as his use of quotes from literary favorites. For our purposes these two books stand out – Pedro Domingo’s The Master Algorithm and Brett King’s Augmented: Life in the Smart Lane. Xi is betting huge on artificial intelligence as a means of social control as well as a driver to the kind of innovation economy that he is promoting. Having been voted to a life term one has to acknowledge that he has the full support of the Communist Party. China plans to invest $100 billion over the next five years to develop AI technology hoping to put its giant corporations; Baidu, Tencent, Huawei and Alibaba in the global driver’s seat.
I can keep playing this parlor game with leaders from all over the globe and the result is the same; the current crop of political leaders are consumed with defining their nations place in a future that will be dominated by technologies that will have the most profound impacts in human history. Geopolitics today is like a game of musical chairs where the rules have not been established. Every nation is scrambling to figure out which side they want to be on. Only two nations have the ability to be the global leader, the U.S. and China; this means that everyone else has to choose alliances or try to go it alone and remain neutral.
Listening to the people who know Trump best is confusing because constantly I find statements supporting Trump as a free trade bull. His international business dealings over the decades would suggest that he’s not opposed to trade, so why all the protectionism with Tariffs and a trade war? Looking back at The Art of War, by Sun Tzu may provide some insight. Sun Tzu taught that the central importance in war is deception. “Even though you are competent, appear incompetent. One with great skill appears inept,” Sun Tzu advised. “Wear them down by fight, foster disharmony, use their anger and pride against them.” We all remember Trump’s midnight tweets: “little rocket man,” “this maniac,” “much bigger button” and so on. While it would be easy, and far more gratifying to just dismiss Trump as a lunatic who has lost his mind on the world stage; I’m forced to consider all contrarian views. So I’m considering here that Trumps actions are tactics and in fact we see the same tactics with his actions at the WTO meeting, his attacks on the Canadian Prime Minister Justin Trudeau, attacks via twitter on Mexico, NATO, the EU, Germany and many more. All Warfare is based on deception. This was one of Sun Tzu’s most important teachings and one that I think is being used extensively in the trade war of 2018. I think most of Trumps’ actions and rhetoric is, at least in his mind a tactic to foster disharmony and wear down his opponents.
We live in a world that is governed by treaties and trade acts where disputes have been refereed at a glacial pace by the World Trade Organization. The alliances forged after World War II were created to protect Europe, namely from Russia and as the world slipped into the Cold War era NATOI became more important. China sees the opportunity in those alliances. Trump can’t function in that world, so following Sun Tzu’s advice, he throws a metaphorical grenade into every meeting, disrupts the natural order and then immediately begins to build new alliances in the way he wants them. The U.S. being aligned with Russia isn’t something China or the rest of the world ever considered. China rising out of emerging market status to become a member of the WTO isn’t something we expected either. But when China started pitching their 2025 plan of One Belt-One Road they expected the U.S. to go on as we always have with statements and negotiations delivered via the WTO. The world thought that bringing China into the WTO would appease China and bring them in line; all it did was strengthen their position. What China didn’t plan on was a U.S President who behaves like a junk yard dog.
Understanding Trade War Economics
A tariff is essentially a tax on trade flows in order to balance the input costs of the goods. As we saw with flat panel displays those tariffs don’t always work unless there is also robust support for the home industry. If a company in China can produce a widget at a lower cost than and equivalent company can in the U.S, the U.S is likely to apply some amount of tariff on that class of products in order to level the playing field for producers in the U.S. We’ve always had tariffs of varying degrees as a means to protect companies and workers in the U.S. Likewise countries around the world have placed tariffs on our goods. A handful of nations have zero tariffs or zero tariff relationships with specific countries. According to the WTO list of highest and lowest tariff nations, less developed nations tend to have the highest tariffs while more developed countries have lower tariffs. That’s the macro picture, but when we look closer we see that Japan, a country with relatively low tariffs has very high tariffs on rice. Likewise the U.S places high tariffs on peanut products to protect our peanut farmers. The line items are where some seemingly unusual policies appear.
Looking at the macro numbers the 2018 trade war gains some perspective.
Global Economy: $80 Trillion
United States Economy: $20 Trillion
China Economy: $12 Trillion
Current Tariffs US: $250 Billion or .0125% of US GDP
Current Tariffs China: $34 Billion or .002% of China GDP
United States Population: 326 million
China Population: 1.4 billion
Goods Imported by US: $506 Billion
Goods Imported by China: $130 Billion
Trade Imbalance: $376 Billion
I think looking at the big picture shows that the cost to either nation is really not all that great from an economic standpoint. The .0125% of GDP that $250 Billion reflects is not going to have a meaningful impact on the U.S economy or global GDP. However, when we look at line item tariffs and zoom in on the micro impacts, yes, someone will get hurt or at least feel the impact of a tariff. If you’re buying a 2018 Harley Davidson with a cost right around $25,000, will you be deterred by a price tag of $27,500? Probably not, but if your dried fruit goes up .50 cents you’ll likely switch brands.
The economics of this trade war are not going to have a meaningful impact, what’s more important in are the tactics; why have the war at all if the economics don’t matter? A look at the size of the imbalance and relating that to China’s One Belt-One Road Initiative is important. Notably that China will run out of tariffs before the US does since we imported over $500 billion in goods and China only imported $130 billion from the US. For anyone who thinks tariffs are a weaponized form of diplomacy, look closer at the China tariff list and you’ll find that its tariff weapon is full of blanks as they put tariffs on trade flows that don’t exist.
For instance China included a tariff on Piped Natural Gas from the US. I checked, we don’t have a pipeline from the US to China. Live Trout, a product the US hasn’t imported from China since 1992 somehow made it on the list. The US did the same when we included Liquefied Natural Gas LNG which we don’t ship to China, but in two years China will be in desperate need of all the LNG it can get. The U.S has recently started shipping LNG, just not to China. China is the world’s second biggest importer of LNG and it doesn’t have any liquefaction plants capable of exporting the fuel. One of my favorites is a tariff on imported radio tape players from China which according to the US Census Bureau trade data hasn’t been imported since 2006. Honestly, someone in 2006 was buying a tape player for their car? Also, that trans-pacific power line that doesn’t exist will be receiving a hefty tariff for Chinese electrical power imports. This is literally a tariff on electricity being imported to China, from the U.S.; we can only assume from a secret under-sea transmission line.
My point is, keep this all in perspective. The stories we hear on the news are all about the extreme and the salacious. The numbers sound big, but they aren’t. The rhetoric sounds expensive, but talk is cheap. The soybean farmer who can’t make ends meet because of tariffs sound horrible; I’d like to look at his books and see if that’s the real cause of his decline or the excuse. The wine maker, widget producer and grain growers that suddenly have cancelled orders hurts. The motorcycle company that is moving ‘some’ manufacturing overseas because of tariffs I’m certain was making those plans long before any discussion of tariffs took place. Yes individuals will feel some pain from these tariffs; we subsidize all kinds of industries, farmers in particular, certainly a solution can be found to alleviate that problem.
This is High Stakes Poker
So why all the phony tariffs mixed in with the real ones? Donald Trump and Xi Jingping sat down at a metaphorical poker table with their respective piles of chips. Odds are in favor that the poker player with more than $500 Billion in chips can out last the player with $130 billion. We are seeing this right now as the last reaction from Trump to Xi was serious enough that we are